The huge fuel subsidies: How to bite the bullet

Martin Jenkins, Jakarta

In Indonesia, much debate has recently centered on how the government should tackle the problem of rising fuel subsidies as the price of crude oil on the international market moves ever higher.

At first glance, one may wonder how the government will cope. After all, fuel subsidies are now set at Rp 63 trillion (US$7 billion) for 2004, far higher than the initial target of Rp 14.5 trillion. This increase is based on a higher oil price assumption of $36 per barrel vis-a-vis $22 per barrel previously to reflect the latest price movements on the international oil markets. Yet even this assumption may prove to be too optimistic given the rising price of oil, which has even exceeded the psychologically significant level of $50 per barrel in recent weeks.

However, the higher fuel subsidies only give rise to a much more modest increase in the budget deficit (to Rp 26.3 trillion compared to the Rp 24.4 trillion previously estimated. As a percentage of gross domestic product (GDP), this is only an increase from 1.2 percent to 1.3 percent. After all, the modestly higher deficit can easily be plugged-- either through foreign or domestic financing. And the size of the deficit is unremarkable: it is well below the 3 percent maximum budget deficit limit imposed on European Union countries, for example.

But is it really good policymaking to continue to heavily subsidize fuel? From a social and environmental perspective it is not. The fact is that just as consumers of yesteryear puffed on cigarettes unaware of the health risks involved, the general public today is deluded into believing that these subsidies are good for them. They could not be more wrong.

Firstly, fuel subsidies are largely enjoyed by the rich -- especially car owners of course. The unfairness of the fuel subsidy policy can be seen in the fact that the more gas thirsty your car is, the more you benefit from fuel subsidies! If you are fortunate enough to own a large SUV or luxury saloon you will be benefiting considerably from the fuel subsidies.

At the current gasoline selling price of Rp 1,810 rupiah per liter, each motorist is probably being subsidized around Rp 2,600 rupiah for each liter of fuel they consume (assuming that premium gasoline if unsubsidized would sell at Rp 4,400/liter). If a Jakarta motorist consumes say 200 liters of gasoline in a month, then they are being subsidized to the tune of Rp 520,000 rupiah/month, or more than the national monthly minimum wage in most provinces of Indonesia!

In addition, fuel subsidies do not encourage conservation of what is ultimately a scarce and nonrenewable resource. When a liter of fuel costs less than a liter of mineral water from the local supermarket what is the incentive to use fuel in a frugal manner?

It should also not be forgotten that the burning of fossil fuels causes massive damage to the environment. Take a look at Jakarta. The huge number of vehicles on the city's increasingly congested roads has made the nation's capital city one of the most polluted cities in the world. Ultimately we all suffer through health problems such as respiratory ailments not to mention the stress from sitting in soul-destroying traffic jams day after day. Is this what we want for our children?

As such, many governments around the world take the decision to tax fuel, and to tax it heavily. The substantial proceeds that can be raised through these taxes can then be used to develop a decent, clean and efficient public transportation system -- something that Jakarta's long-suffering residents would certainly benefit from.

Another concern is that higher fuel subsidies provide an even greater incentive to smugglers who stand to make handsome profits by illegally exporting fuel products to neighboring countries such as Singapore. Given Indonesia's vast coastline and poor law enforcement it is likely that a lot of subsidized fuel leaves the country this way.

But even though fuel subsidies are misdirected, unfair, costly and lead to the misuse of a scarce resource, the government still has to be very careful in how it goes about eliminating them. To simply discontinue the policy of subsidizing fuel would most likely lead to disaster. Why would this be so?

Firstly, inflation would soar. According to economists at Danareksa Research Institute (dRI), inflation would rise by 0.70 percent for every 10 percent increase in the price of fuel. If then, the fuel subsidies were immediately eliminated and say the price of gasoline doubled (a conservative assumption given that premium gasoline is sold at Rp 1,810/liter, or way below its current estimated market price of around Rp 4,400), Indonesia's annual inflation rate could conceivably rise from between 6 percent and 7 percent to an astonishing 13 percent to 14 percent.

Higher inflation -- especially in transportation prices -- could have devastating consequences. Strikes, public protests and even riots could easily ensue, as was the case when the IMF advised former president Soeharto to hike fuel prices sharply as the financial crisis unraveled in 1998.

The decision to hike fuel prices contributed significantly to the social and political unrest that brought about his downfall. Nigeria is another good case study: That country saw widespread chaos when its government tried to end subsidies on refined oil products in 2003.

And with the higher inflation, it should also be realized that the cost of financing government floating rate bonds (which total around Rp 225 trillion) would also increase dramatically. As such, the government might not save as much as it had at first expected by taking the decision to end the fuel subsidies.

Besides surging inflation, such a severe shock on the economy -- arising from hiked fuel prices -- would likely hammer investor confidence. This could lead to plummeting share prices on the Jakarta Stock Exchange and a run on the rupiah as capital flows out of the country. All in all, the economy would be badly hit and the current upward growth momentum could be lost.

Given these considerations the government appears to be stuck between a rock and a hard place: Lifting the oil subsidies at once would likely lead to social unrest and economic catastrophe whereas maintaining the subsidies is inappropriate given they are misdirected, costly and ultimately unsustainable.

As such, the best solution may be to take the middle way: That is to lift subsidies gradually and in phases, but not too quickly, so as to avoid a large shock on the Indonesian economy but also to ensure fiscal sustainability. dRI's model shows that a 20 percent cut in the size of fuel subsidies each year for five years would mean that the nation's budget would be in good shape in the coming years.

In addition, better targeting of subsidies and educating the general public to appreciate that fuel needs to be used frugally are also very important.

But even though higher fuel prices are inevitable, people have little reason to complain. After all, it does not make much sense if fuel is cheaper than water, does it?

The writer is Market Analyst at the Danareksa Research Institute. He can be reached at martin@danareksa.com.